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Sunday, October 2, 2011

Debt & Taxes

In my last post about the national debt, I said I would move forward by looking at what the "debt crisis" might mean to our clients' financial plans. One obvious area of concern is taxes. The conventional wisdom seems to be that tax rates will go up as part of any solution to reducing the debt. This makes some believe that it is a good idea to pay taxes now, if possible, at today's rates, instead of the higher rates that may prevail in the future. This includes strategies like converting traditional IRA's to Roth IRA's, thereby paying tax on the traditional IRA's today and not in the future. There are also ways that people can move earned income forward and pay tax, or sell appreciated real estate or other investments in order to pay the tax now.

The problem with these ideas is that they are driven by assumptions about what the tax code will be like in the future. As my Dad taught me, this is letting the "tax tail wag the investment dog" and it is generally not a good idea. A great example of this problem is the tax shelters sold to individuals in the late 1970's and early 1980's. This was a time of high tax rates and poor investment returns. An entire industry came into being around selling limited partnerships that offered no investment return, but potentially large tax savings. To many people, this seemed like a no-brainer because in the world they saw, tax rates would always be high and stock markets would never again be profitable. Then a funny thing happened, the world changed. Ronald Reagan became President, tax rules were significantly changed in 1982 and 1986, and the stock market entered an 18 year bull market. All of those limited partnerships became basically worthless.

Similar things could happen now. Many smart people think that the most important thing the government can due in the face of the "debt crisis" and economic slump is to simplify the tax code. Here's one article of many that makes that point. Here's another tax plan from economist Larry Kotlikoff, which like many of the plans floating around lowers income tax rates for everyone, eliminates most tax deductions and includes some sort of national sales tax. I have no interest in endorsing one tax plan over another, but if serious tax reform does happen it will change everything. (Unfortunately there is an army of lobbyists in Washington whose jobs depend on an ever more complicated tax code, but that's another story)

So from the perspective of financial planning, I believe it is a bad idea to make significant financial decisions based around the idea that tax rates will be permanently higher in the future. This may happen or it may not. I still believe the best idea is to keep current taxes as low as possible and take it one year at a time.